Idiosyncratic Risk Matters!

Abstract

This paper takes a new look at the predictability of stock market returns with risk measures. We find a significant positive
relation between average stock variance (largely idiosyncratic) and the return on the market. In contrast, the variance of
the market has no forecasting power for the market return. These relations persist after we control for macroeconomic variables
known to forecast the stock market. The evidence is consistent with models of time‐varying risk premia based on background
risk and investor heterogeneity. Alternatively, our findings can be justified by the option value of equity in the capital
structure of the firms.